The Upside Of The Fiscal Cliff

1. We are finally starting a national discussion of spending-taxation trade-offs

2. We are at last starting to (grudgingly) accept there is no free lunch, what I call the Free Lunch Fantasy of limitless borrowing at near-zero interest rates: taxes for upper-income wage-earners will revert to previous levels while those drawing Federal dollars must accept reductions in spending.

The last decade’s fantasy that we could borrow our way to prosperity while lowering taxes on upper-income earners (because it’s so cheap to borrow trillions at near-zero interest rates) is finally running into reality-based resistance: interest on all that debt is starting to squeeze the spending everyone wants, and long-term rates might rise despite the Federal Reserve’s constant intervention.

That would eventually raise interest costs paid by the Federal government.

How can interest rates rise if the Fed is buying much of the Federal Debt?

The first part of the answer is to accept the fiscal consequences of the Baby Boom entering Social Security and Medicare at the rate of 10,000 retirees a day: Federal spending will rise far faster than tax revenues, dwarfing the relatively minor spending cuts being discussed.

Now of course, retirees are also dying, so you might think this is only half the story. However, the people who die are, on the average, 15 years older than the new retirees. So when the number of retirees surges in 2011, the number of deaths is still from the pre-boomer group, and stays roughly constant.In other words, Social Security and Medicare outlays continue to increase for 15 years, until the number of retirees dying rises to match the number of new retirees.

Simply put, the retirement and healthcare systems were not designed to match the nation’s demographics, nor was Medicare designed to limit costs, which continue to rise faster than inflation, despite various cost-saving measures.

Combine these trends with stagnating wages and employment and you get a triple-whammy: soaring number of retirees, rising Medicare costs per retiree and a stagnating tax base.

Federal spending and thus borrowing will rise unless the promises made are slashed.

This sets up an increasingly unstable dynamic: the Federal deficit of $1.3 trillion will continue to rise, forcing the Fed to increase its balance sheet as it buys hundreds of billions of dollars of newly issued Treasury bonds. Is there no upper limit on the Fed’s purchases of Treasury bonds? Even if there is no financial limit, there is a political limit, as the Fed’s policies will be recognized as counter-productive failures as the 2013 recession kicks in.

The Fed’s political room to maneuver is shrinking, and its policy of keeping interest rates at near-zero by buying unlimited quantities of mortgages and bonds has limits. Once the markets sniff these limits, yields on long-term bonds will rise, pushing up borrowing costs. The Fed can play around with yields by selling long-term bonds and buying short-term bonds, but these Operation Twist manipulations also have limits.

The Fed’s purchases of Federal debt enabled the Free Lunch fantasy. Rather than let the market price Federal debt higher, which would have set limits on Federal borrowing, the Fed’s purchases of Treasury bonds suppressed the recognition that there was a cost to essentially unlimited Federal borrowing.

All these policies that enabled the Free Lunch Fantasy are reaching financial and/or political limits. The fiscal cliff is one expression of this recognition, and it is very positive that Americans are finally facing up to the personal costs of dealing with reality: higher taxes and lower Federal spending are no longer abstractions to be borne by others. We will pay more taxes and we will get fewer benefits/Federal contracts, and these reductions in income will negatively impact the economy.

About The Author

Charles Hugh Smith writes the Of Two Minds blog (www.oftwominds.com/blog.html) which covers an eclectic range of timely topics: finance, housing, Asia, energy, longterm trends, social issues, health/diet/fitness and sustainability. From its humble beginnings in May 2005, Of Two Minds now attracts some 200,000 visits a month. Charles also contributes to AOL’s Daily Finance site (www.dailyfinance.com) and has written eight books, most recently “Survival+: Structuring Prosperity for Yourself and the Nation” (2009) which is available in a free version on his blog.